Get Ready for China’s M&A Era

(Bloomberg Markets) -- Hu Xiaoling has been eagerly waiting for China’s debt clampdown for more than a decade. Hu, a co-founder of Beijing-based alternative-asset firm CDH Investments, says some of her industry peers worry that China’s deleveraging campaign will sabotage private enterprise. But she thinks it will only harm companies that are overleveraged. With a view that banks would eventually roll back excessive lending, Hu says CDH has been targeting businesses with good cash flows and has avoided the temptation to invest in overvalued companies. CDH was started in 2002. Before that, it was part of China International Capital Corp., a foreign securities venture with Morgan Stanley and other partners. As of June, CDH managed $18 billion in assets, having expanded into areas as diverse as credit and wealth management. The firm, with more than 150 investment professionals on staff, has invested in more than 200 companies. Hu’s biggest deals include the $6.8 billion buyout of Belle International Holdings Ltd., China’s largest women’s footwear maker, in 2017. In an interview with Bloomberg Markets, Hu says CDH has been preparing for a correction in the Chinese market, and it looks like the bet is beginning to pay off. Public company valuations have already cooled in China; private markets tend to follow suit. Hu says CDH is now ready to seize M&A opportunities at bargain prices. 

Cathy Chan: You were one of six co-founders of CDH in 2002. What’s the biggest lesson you’ve learned?

Hu Xiaoling: We never follow the herd. In the past 10 years, starting from 2008, the Chinese A-share market has given a particularly high valuation to mediocre companies. Because they are small and so easily driven by market hype, valuations can reach 50 to 100 times price-earnings multiples. In fact, some funds have been investing in these mediocre companies, betting on an A-share listing, and are making particularly gigantic returns. 

CC: How does CDH respond to the market frenzy?

HX: This temptation is actually quite big. We do have team members voicing their frustration after seeing rivals invest pre-IPO in A shares and make good fortunes. As an organization, you have to resist this temptation. Unlike venture capital, our PE funds have zero tolerance for losses. We may have one or two problematic investments out of a few dozen we made over time, and we discover every time that if we don’t have absolute persistence, there is a problem.

CC: Has CDH missed any boats?

HX: A lot. There must be some misses. If you don’t miss some, that implies you must also have already made a lot of mistaken investments. 

CC: What’s changed the most in the past two decades?

HX: Before 2007 a very unexceptional consumer-goods company could post a 20 to 30 percent profit increase, and a good one might have 50 percent to 60 percent because they had much better cash flow. After 2008 the lackluster companies are barely making profit, and their debts continue to rise, leading to overleveraging and potential bankruptcy problems today. These are the seeds buried in the past years. These companies simply did not know how to manage major resources, because they were not good enterprises.

CC: China’s economy has experienced tremendous growth since the early 1990s. What role has private equity played in that?

HX: The rapid growth of Chinese companies is mainly a result of China’s economic development. If I say private equity and its capital have promoted China’s economic growth, I think my statement is rather arrogant. What private equity does is effective resource allocation, which is why this industry was created. When resources are allocated to companies and people who have no capability to deploy them efficiently, PE industry professionals should feel guilty about it. Capital itself does not create GDP. Our role as a PE investor is to allocate resources to entrepreneurs and companies with good vision, capability, and acumen. But in the past few years, because of the immature investment visions of some people, I have seen a lot of mismatched resources. 

CC: What has prevented the efficient allocation of resources in China? Why are some Chinese companies still not properly run and unprofitable despite the country’s high economic growth?

HX: Before 2007 we noticed many companies had been growing rapidly for 15 years and it was easy to make a fortune in China. After 2007, because of the emergence of better companies, the more troubled ones were starting to struggle. We have said China may be entering the era of M&A. We thought we would have reached that stage [by now], but because the government pumped 4 trillion yuan [$593 billion], some say 10 trillion yuan, in the system, those who were prepared to surrender were given more bank loans. This is a resource mismatch and is already leading to the bigger problems today.

CC: Public company valuations have come down quite a bit. Private markets tend to lag behind. How much of a decline are you expecting in terms of private valuations?

HX: We believe China valuations in certain areas have been excessively high since 2014, and we don’t think constant financing at high valuations is a thing that will last forever. Maybe I am a bit overconservative or foresee the impact of possible deleveraging too early, but we have been looking to invest in companies with particularly good cash flow since then. I’ve told our cash-rich portfolio companies to keep their money, because there will be very meaningful opportunities during the process of deleveraging. You’ll be able to do more with less money and buy more of the target at a lower price. As a private equity investor, we look at things in a three- to five-year horizon. I personally made preparations over the past two to three years for the upcoming corrections. I hope that through the next two or three years, our companies, which have good cash flow, can take advantage of this opportunity to do better M&A deals. 

CC: What’s the outlook for 2019?

HX: We haven’t made a big move yet, because we think the current prices aren’t right. Over the last few years, M&A EV/Ebitda multiples in the U.S. were 9.5 times, and China cross-border acquisitions in consumer and manufacturing sectors were 12 times to 14 times. I think 7 to 8 times multiples are more reasonable. Now there are ample [M&A] opportunities, but since there are so many, we feel like we have more bargaining power to pick the best. Deleveraging has kick-started this process. There is also systematic change, with many founders, entrepreneurs, and management seeking successors after starting their businesses in the ’90s. 

CC: With private enterprises under more pressure due to China’s deleveraging efforts, does that translate into more opportunities for private equity investors?

HX: There are some saying that deleveraging will sabotage the entire private enterprise segment, but what I see is that the [government] measure only targets overleveraged companies. These companies are the ones that were allocated capital but failed to run their businesses properly. Now they’re hardest hit because an order [from the government] is being put in place. In July hundreds of A-share companies saw their stock losses exceed collateral underlying stock. These companies are the ones that were assigned excessive valuations by the A-share market and claimed to be 10 to 20 billion [yuan] companies. They made acquisitions beyond their appetite. They found these targets couldn’t be digested and have now started to dispose of them. Our team is now seeing a lot of these targets available in the market. In fact, I had been planning to acquire some companies in the 2008-2009 period after the financial crisis hit, but the banks kept giving loans to the problematic companies, allowing them to survive and making them reluctant to sell. 

CC: Your firm specializes in investing in companies that cater to consumer demands. Do you think consumer sentiment has been impacted by the U.S.-China trade war? 

HX: I think the biggest concern this year is the impact of deleveraging rather than trade wars. 

CC: How are consumer demands changing in the retail sector in China, and how does this compare to the U.S.?

HX: In the U.S. it may take 60 to 70 years to witness changes in consumer habits, from mass consumption to brand consumption, and then to quality consumption, but China only needs 20 to 25 years, or about one-third of the time.

China’s cities and regions are numerous and diversified. Different regions have different stages of development, and you just can’t generalize. I expect 30 percent of the population will gradually move to quality consumption, and maybe one-third of this mass-market population is gradually entering the consumption category defined by brand loyalty. The rest will stay in the mass-­market category for a while.

CC: Why is China experiencing a faster consumer transformation than the rest of the world?

HX: It has something to do with globalization, because information [about products and services worldwide] is more freely available. Second, the Chinese want to grow even faster, because they were hungry before. As there are too many people in the country, everyone will make stronger efforts to survive. A fast-changing world is especially good for the PE industry, as it constantly provides opportunities for investors. You will have a chance only when there is change. 

Chan is a private equity reporter at Bloomberg News in Hong Kong.

To contact the editor responsible for this story: Siobhan Wagner at swagner33@bloomberg.net

©2019 Bloomberg L.P.